The United States Loans Auditor (2010) reported that the number of foreclosures since the housing crisis started in 2007 to present is over fifteen million. RealtyTrac (2011), the online marketer of foreclosed homes, reported that one in 45 households or 2,824,674 properties nationwide were defaulted in 2010. Today, every 10 seconds, a homeowner in America is receiving a foreclosure notice. One homeowner in every one hundred thirty six is in receipt of the notice that will end their American Dream. Forecasters predict that at this current rate over twenty five million homes will be in foreclosure by the end of 2011.
In the United States, subprime borrowers are classified as having a FICO score below 640. These borrowers have credit ratings which might include; limited debt experience, no possession of property assets that could be used as security, excessive debt, a history of late or missed payments, failure to pay debts completely and bankruptcy. According to Hiber (2010) “these borrowers do not meet Fannie Mae or Freddie Mac underwriting guidelines for prime mortgages” (p. 24), which disqualifies them from acquiring loans at the usual market interest rates.
During the 70’s borrowing was a simple business and bankers knew their customers. When people wanted to buy a house, they applied for a loan from their local bank. The loan stayed with the bank and the buyer paid the bank over a period of years. However, there was a huge demand for housing during that time, so the government ordered Fannie Mae and Freddie Mac to purchase mortgages from community banks, guaranteeing them against default. Hiber (2010) argued that this system of security had contributed to the crisis because these banks had no financial incentive to make sure the borrower would not default. The result was discrimination in lending based on the underwriting guidelines imposed by Freddie Mac and Fannie Mae.
But in 1977, the Community Reinvestment Act was passed to address the discrimination in lending practices. The act encouraged banks to lend to low and moderate income neighborhoods. While this was an admirable goal, the banks during that period were forced to engage in imprudent lending. Hiber (2010) believes that the housing market began to bubble because the banks extended credit to the subprime borrowers. The people who previously do not have access to the credit market had the capability to borrow and buy houses. These loans were first called “non-conforming” loans. It means loans made to people who may have difficulty maintaining the repayment schedule.
Subprime lending was a major contributor to the increase in home ownership rates and demand for housing which drove home prices higher. Realestate (2010) reported that between 1997 and 2006 the price of a typical American house increased by 124 percent. But this numbers could not have been possible if there was enough regulation by the Feds. Instead the US congress enacted the Alternative Mortgage Transaction Parity Act of 1982 which promoted free enterprise by reducing regulation. Wallison (2011) argues that, “the act permitted the creation of Adjustable rate mortgages, balloon mortgages, and negative amortization” (para 2). This meant the bankers have to loosen their mortgage standards even more to produce more products. This created the jargon of Subprime lending called NINJA loans (loans to people with No Income, No Job, and no Assets). The buyers who did not qualify for standard mortgages at prime interest rates would be given higher interest rate mortgages.
However, even if there was deregulation, the average household income didn’t really increase so it was financially impossible for subprime borrowers to pay for the higher interest loans. But in1986, the Tax Reform Act was passed, which retained the tax deduction for interest on mortgages. This act made home equity loans highly attractive to consumers who were expecting their home values would continue to rise, and this eventually led to an unhealthy amount of debt in the financial system because even if consumers can’t afford the high prices, some began to purchase subprime mortgages for the incentives.
Another reason why more consumers opted to purchase subprime mortgages is an action by the Federal Reserve during the 2001 recession. The Federal Reserve lowered its interest rate which went down to one percent and remained that way until 2004. With interest rates at an all-time low, the financial services industry went to invest in the real estate market. The availability of money also led to an increase in demand for home ownership among consumers. This was a time when not a lot of houses were available, which led to an increase in home prices.
During this time two shifts occurred in the housing market. Property purchases shifted from buying a place to live to buying an investment, and lenders offered more loans to risky buyers. US Loans Auditor (2010) reported that in 2005, 40 percent of home sales were for investment purposes or for second home and the mortgage denial rate dropped to 14 percent in 2003 from 28 percent in 1997 (trend section).
Because much of the growth in the housing boom was in subprime mortgages, this type of market quadrupled from $332 billion to $1.3 trillion (Realtytrac, 2010). According to Mishkin (2009), “in 2000 about 70 percent of all loans were conventional prime, 20 percent were FHA, 8 percent were VA, and only 2 percent were subprime” (p.299). But, “in 2006, 70 percent were still conventional prime, but now fully 17 percent subprime, with the balance being FHA and VA”(p.300). This caused a lot of worries in the market because of the risks, but the financial institutions developed complex financial instrument which they believe reduced the risk. They pooled mortgages into groups called tranches/bundles.
Lenders bundled American subprime and American regular mortgages which were traditionally isolated. According to Brown (2010), “the bundles of mixed mortgages were based on Asset backed securities which the probable rate of return looked excellent since subprime lenders pay higher premiums, and the loans were secured against saleable real-estate so theoretically this could not fail” (Para. 7). Lenders believe that even if some borrowers were to default, most borrowers in these bundles would not, which lowers the overall risk.
On the other side, to lure more consumers to purchase subprime mortgages, other innovative lending practices were developed. There is the 2/28 ARM loan, no interest for 2 years but increases substantially after that. Piggyback loans, a combination of two loans with no down payment but result in high payment and consumers have less incentive to walk away when payments start piling up; other examples are stretch loans and stated income loans. The borrowers, who cannot make the higher payments once the initial grace period ended, always have the option to refinance their mortgages after a year or two of appreciation. These loans sounds too good to be true, but during the housing boom, mortgage backed securities were considered the best type of investment, and the demand for housing skyrocketed. According to Hall (2010), from 2002 to 2006, real estate prices rose by almost 32 percent.
Builders were forced to keep up with this demand which resulted to a lot of surplus, and in 2006, the first decline in nationwide housing prices since 1991 was recorded. By mid 2006, house prices began to decline in many parts of the country and refinancing became more difficult, and because many borrowers had adjustable rate mortgages their rates started to increase. Those borrowers who found themselves unable to escape higher monthly payments by refinancing began to default, and then the number of foreclosures increased.
Realtytrac (2010) further notes, average housing prices dropped 20 percent from 2006 to 2008. As more borrowers stop paying their mortgage payments, foreclosures and the supply of homes for sale increased. This placed downward pressure on the housing prices, and because people started to default in mortgage payments, this reduced the value of mortgage-backed securities, which affected the net worth and financial health of the banks.
According to Bryfonski (2010) by early 2007 borrowers began to default in large numbers which caused the inflated house-price bubble to burst, this resulted to the collapsed confidence in the mortgage market, that by mid 2007 these assets were considered to be toxic (p.43). She also added that by the 3rd quarter of 2007, Merrill Lynch, one of the few foundation of mortgage lending, experienced a collapse on its investments tied to subprime lending (p. 43). Many other banks who took on significant debt reported that many of their assets were also toxic. These assets were devalued so much that they could not be sold during that time. The banks respond quickly, they stopped lending money which eventually created a credit crisis and freezed the economy.
In an effort to stabilize the economy, unfreeze credit markets and prevent further erosion of confidence in the US banking system, the US congress authorized $700 billion to bail out the banks in 2008. But the aforementioned data suggests a significant number of mortgage loans belong to lower-income, higher-risk, subprime borrowers who had already gotten a break on their mortgage payments via federal programs to reduce defaults. According to Foroohar (2011), “these so-called modified loans showed that 45 percent of them had been canceled, meaning that the borrowers are very likely redefaulted, even after the payments had been adjusted”(Para. 4). So today, we might be in the verge of a double dip recession.
While doing this paper I found out some historical data, legislations, and regulations which started the subprime lending. I also found out that many subprime borrowers took out adjustable-rate mortgages thinking they could get lower initial interest rate so they could avoid high mortgage payments. But with potential annual adjustments of more than 1 percent per year, these loans actually ended up costing much more.
For example: A $500,000 loan at a 4 percent interest rate for 30 years equates to a payment of about $2,400 a month. But the same loan at 10 percent for 27 years equates to a payment of $4,220. This means that 6 percent increase in the rate caused more than 75 percent increase in the payment. This is even more apparent when the lifetime cost of the loan is considered. The total cost of the loan at 4 percent is $864,000, while the higher rate of 10 percent would incur a lifetime cost of $1,367,280.
Looking at these numbers I cannot imagine how banks lured the public into purchasing ARM mortgages, and to make the situation worst, these banks bundled the subprime and prime mortgages because of deregulation on these types of products. In my opinion the government should punish these banks and not just save them from their mishaps by simply bailing them out. What happened to this crisis was a chain of reaction very similar to the housing bubble but only in the opposite direction. The rising number of foreclosures, tied with high unemployment rate hindered the housing rebound, and the result was a horrible recession. Then the borrowers over rely on the expectation that the future of the economy will stay the same. The result was a wave of foreclosures and banks ended with a lot of bad loans on their books. It was a financial catastrophe.
However, there are a lot of ways to help end this crisis. In my opinion we need start by setting clear rules on the market that promotes transparency and accountability. We also need more regulation in banking, and the Feds should make sure they have micro-prudential supervision so that customers and taxpayers are protected against excessive risk taking that may cause banks to fail. The Feds should also make sure that the whole financial sector retains its balance. I agree with nationwide banking and bank consolidation, I believe it will produce an efficient banking system and less vulnerable to banking crisis.
According to Mishkin (2009), “on one side of subprime lending are those who point to predatory advertising and bait and switch tactics that coerce naïve home borrowers into obtaining loans they cannot possibly repay, while on the other side are those who point to the increase in home ownership attribute to these loans as a positive outcome” (p.300). I stand with the first argument, because the real problem is not bad loans and bad borrowers—it’s just bad lenders.
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